The Fat Tail

Last night I attended the book launch party for the
The Fat Tail, a new book co-authored by Ian Bremmer and Preston Keat. Bremmer is President and Keat is Director of Research at The Eurasia Group, a political risk research firm. Admittedly, I have known Bremmer for almost 10 years and my opinion may be biased, but I consider him to be the foremost expert on political risk. I have heard him deliver a number of speeches over the years. He is an excellent speaker who makes extremely cogent arguments.

The title of the book comes from the bell curve. In a normal distribution, there is a 67% probability that an outcome will fall within one standard deviation of the mean. Unlikely outcomes occur at the tails. In a distribution with fat tails, the probability of unlikely outcomes is higher. Bremmer and Keat are implying that investors often underestimate the probability that unlikely outcomes will occur. For example, they begin the book with the 1998 crisis in Russia and tell us how the leading experts assured investors that Russia would not default on its debt. Yet that's exactly what happened. The book is full of such examples.

Because I have just begun to read the book, I can't provide a complete analysis. So far, however, I find it interesting and timely. It also fits nicely with Bremmer's recent assertion that financial regulation and the U.S. Congress represent the greatest political risks of 2009.

More on the UAE

As my readers know, I traveled to Abu Dhabi and Dubai two weeks ago. I was invited by the CFA Institute to address investors at the Abu Dhabi Investment Authority (the world's largest sovereign wealth fund), Mubadala, and Hawkamah. Perhaps I am now more aware of events in that part of the world because of this trip. Maybe this is why I have noticed quite a bit of news about the United Arab Emirates since I returned home. For example, immediately following my return, Dubai made news by denying an Israeli athlete a visa to compete in a major tennis tournament. Soon after it made news again when it received a $10 billion bailout from the UAE central government. Dubai, which just a year ago was one of the world's greatest financial success stories, now seems plagued by poor decisions and economic turmoil.

Yet one of the best articles I have read in recent weeks was one written by Zvika Krieger in the Wall Street Journal. The title of his commentary says it all: "There's No Reason to Gloat Over Dubai's Fall." Mr. Krieger argues that the UAE is not perfect, but it is moving in the right direction. I agree. His op-ed inspired me to write a letter to the editor in support of his view.

Greenspan Was Right in 1996

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.

Alan Greenspan, Dec. 5, 1996


On the day Alan Greenspan spoke those now famous words warning that stock prices might be too high, the Dow Jones Industrial Average closed at 6437.10. Yesterday, more than 12 years later, the Dow closed 16% higher at 7465.95, which comes out to about 1.2% on an annualized basis. Of course, the Dow peaked at more than 14,000 before falling back to current levels. If anything, this should cause investors to question the wisdom of long-term, buy-and-hold investing. That approach is akin to simply sticking your head in the sand and ignoring signs of trouble. A strategy of active asset allocation, i.e., taking money off the table after rallies and buying more after selloffs, produces much better results over the long term.

Dubai May Be Struggling, but Abu Dhabi Looks Strong

I'm back from Abu Dhabi and Dubai. I'm still a little jet-lagged, but I got a good night's sleep for the first time in a week. Here are some more thoughts about my trip.

The United Arab Emirates consists of seven emirates. The best known are Dubai and Abu Dhabi. When it comes to economic development, Dubai is considered the more aggressive one. Dubai embarked on a plan to quickly become the major financial center in the Middle East and one of the most important in the world. There was a tremendous amount of money spent on infrastructure. (Reminds me of the Obama stimulus plan.) Beautiful buildings and roads were planned and constructed. As I said in an earlier post, Dubai is at the cutting edge of architecture and construction.

While I was in the U.A.E., The New York Times published an article warning that the economic boom in Dubai has come to an end. (I thank Vitaliy Katsenelson and Todd Weintz for bringing this article to my attention.) I had already heard rumors of many of the things discussed in that article. Because I spent less than 24 hours in Dubai, I did not get a complete picture of the economy. I had to wonder, however, how there could possibly be enough demand to justify all of the construction going on. To my eyes, Dubai certainly seemed like a busy place. There was plenty of traffic on the streets and the Al Bustan Rotana Hotel where I stayed was busy enough, but I do not have a personal point of reference to make any comparisons.

I was told by some individuals that business activity is way down. Construction has apparently been suspended on some buildings. Most workers in Dubai--from laborers to executives--are from someplace else. One young finance executive told me he was concerned his company would be laying people off soon. A driver told me things were getting bad and many people were going back home or looking for jobs elsewhere. (Sounds a bit like the situation in the U.S.). Given a new law that imposes a heavy fine for disparaging the economy, I wondered if they were being cautious with their comments.

I spent about six days in Abu Dhabi and things there seemed perfectly fine. Abu Dhabi has been more conservative with its economic development plans. There is plenty of construction going on, but there are no obvious signs of overbuilding. People in Abu Dhabi appeared more confident about the local economy. Those in the finance industry were extremely concerned about the global economic slowdown, but not so much about the situation in Abu Dhabi.

Abu Dhabi also has one major advantage over Dubai. It has plenty of oil. While the plunge in oil prices has delivered a blow, this emirate can still generate tremendous cash flow from oil production. Yet those managing the Abu Dhabi economy understand the importance of diversification. Abu Dhabi appears to have struck just the right balance between relying on oil and seeking other sources of income. In fact, Abu Dhabi has the potential to become a major tourist spot. The Emirates Palace Hotel is right on the beach and has several swimming pools. The weather is almost always sunny. It is a perfect spot for a family vacation. The Sheikh Zayed Mosque is magnificent and open to the public for visits. Indeed, during my stay I noticed that Abu Dhabi was full of tourists, many of them German speaking. Abu Dhabi also has a world class golf course. The Abu Dhabi Golf Championship is on the European tour and offers $2 million in prize money.

There may be some friendly competition going on between Dubai and Abu Dhabi, yet at the end of the day, these emirates are a part of the same nation. If things get bad enough for Dubai, Abu Dhabi will likely come to its aid, especially if oil prices rise as global economies emerge from their collective recession.

Impressions of Dubai

I am back in Abu Dhabi after a short trip to Dubai. Before going there, I had heard a lot about all the construction going on in Dubai. Yet it was still a surprise to see it with my own eyes. With all the skyscrapers, Dubai reminded me a little of New York City except that everything is brand new and sparkling clean. There are so many buildings, and perhaps even more that are still under construction. It is hard to believe there is enough demand for all that space. In fact, I heard some projects have actually been stopped midway through. Given the global recession, it seems funding is drying up and some of the projects may not be completed at all. I've also been hearing that many foreign workers are losing their jobs. Some are returning home, others are trying to find jobs in Abu Dhabi where the economy is still good.

Nonetheless, Dubai is an architect's dream. Imagine having a client ask you to design the most outrageous building you could think of without regard to the expense. The Bourj al-Arab Hotel looks like a sailboat (dhow). Another building looks like a jet airplane. Some buildings are straight; others are curved. Some look like they could be fitted together like Lego pieces. The building that houses the indoor ski slope looks like it could tip over. They are really at the cutting edge of what can be done with construction.

While in Dubai, we made presentations to members of Hawkamah, the institute for corporate governance. This was also sponsored by Mudara at the Dubai International Financial Center. There was intense interest in our presentations and we were peppered with questions. There is keen interest in promoting good corporate governance practices in this part of world.

I finally got a chance to relax and catch up on some sleep. Unfortunately, I am returning home just as my body has adjusted to local time. I'm sure there will be more sleepless nights to come.

First Impressions of Abu Dhabi

As the Obama team gets ready to stimulate the U.S. economy, I flew off to Abu Dhabi to see how things are on the other side of the world. I will be giving a talk tomorrow to the Abu Dhabi Investment Authority (ADIA), then I'm off to Dubai.

So far I am very impressed. I flew over on Etihad Airways, the national airline company. It is a very long flight. Fortunately, I was in business class. Both the service and food were great and the time went by rather quickly. After clearing customs, we took a drive through the city. There is a lot of construction taking place and there are cranes everywhere. Although I hear the economy has taken a hit from the fall in oil prices, that is not readily noticeable.

I am staying at the Emirates Palace Hotel, which without a doubt is one of the finest hotels in the world. It really does look like a palace inside and out. The hotel is located right on the beach on the Persian Gulf. The architecture is beautiful. Everything is very geometric. The inside of the hotel has marble everywhere. I am going to catch up on some sleep, then it's off to dinner. There are several interesting restaurants in the hotel. More later.

January Roundup From Forbes Growth Investor

The following is from the February issue of the Forbes Growth Investor.

Despite staging a bit of a rally toward the end of 2008, stocks plunged again to kick off the start of a new year. According to data from Ibbotson Associates, last month’s selloff in large-cap stocks was the worst ever for a January. An old Wall Street adage says,“As goes January, so goes the year.” This is not an encouraging sign for investors who are long. Those who believe in adages and indicators should at least take some solace from the Super Bowl, since it pitted two teams from the old NFL against each other; a good omen for stocks.

Unfortunately, the news continues to be bad on the economic front. Most economists were expecting a large retreat in fourth quarter GDP. Yet the Advance estimate, a decline of 3.8%, was better than the consensus expectation. Investors seemed relieved at first. However, they quickly changed their minds once they realized that increased government spending, a $6.2 billion build in inventories, and an $80 billion decline in imports largely explained why the GDP report was not worse than it was. This was the first build in private inventories in at least two years. Companies were producing more than they could sell. During the current (first) quarter, however, businesses have been laying off workers at an accelerating rate so production should slow. As for international trade, it too is slowing appreciably. And it wasn’t just imports that declined. Exports were off $83 billion.

There is a real lack of demand on the part of consumers. Other than necessities, people are not buying anything. This is not simply due to a lack of available credit. There has been a real change in the mindset of American consumers. We are rapidly transforming from a nation of spenders into a nation of savers at precisely the wrong moment. No one wants to spend money—even those who are relatively well off and gainfully employed—when coworkers and neighbors are losing their jobs. Large numbers of clothing stores, electronics stores, and automobile dealerships are simply shutting down for good.

Lack of demand is also plaguing the housing market. New home sales have fallen off a cliff. Just a few years ago, home builders were selling 1.2 million new houses a year at an average price of almost $300,000 each. These days they are selling only one-fourth as many houses at an average price that is almost 20% less. At the current rate of sales, it will take 16 months to clear the inventory of new houses. It is inevitable that at least a few of the publicly traded home builders will not survive this crisis as independent entities.

Things are a little rosier for existing homes. Sales climbed 6.5% in December thanks largely to falling prices and growing interest in foreclosed properties. Inventory fell almost 12% in just one month. It is possible that we are finally approaching a bottom in existing home prices. I’m still calling for that to happen by late spring. While stable housing prices are key to restoring confidence in the economy, the days of thinking about residential housing as an asset class are probably gone for a long time. It is good to get rid of the speculation in this sector.

Dow 36,000 Is Nothing But A Book Title Now

The Dow Jones Industrial Average is currently at about the same level it was in early 1998. This means that, ignoring dividends, investors have earned nothing in 10 years.

In March 1999, immediately after the Dow broke above 10,000 for the first time, James Glassman and Kevin Hassett published their now infamous op-ed in the Wall Street Journal called Stock Prices Are Still Far Too Low. They argued that investors were overestimating the risks associated with investing in stocks. They argued that stocks were no more risky than a government bond.

Perhaps to demonstrate just how bullish they were on stocks, they also published a book that same year titled, Dow 36,000. They weren't trying to imply that the Dow should reach 36,000 some day. No, they were insisting that the Dow should be at 36,000 right now (i.e., in 1999).

Their point was that investors were wrong to think that stocks were risky simply because stocks were volatile. Because history showed that stocks outperformed bonds over the long term, the authors argued that stocks were really no more risky than bonds. In fact, they argued that the appropriate risk premium for stocks is zero.

This reminded me of a debate I had many years earlier about mortgages. My opponent at the time was arguing that the best mortgage is always the one with the lower interest rate. My point, however, is that cash flow must also be considered. A one-year interest free mortgage is clearly cheaper than a 30-year mortgage at 6%, yet there aren't many borrowers who have the kind of cash flow needed to service that one-year mortgage.

Likewise, stocks have outperformed bonds over the long term and may continue to do so in the future. But not all investors can stomach the volatility. Investors have cash flow needs. They can foresee some of those needs, but they can't foresee them all. This is why investment advisors never tell their clients to put all their money in stocks even though they believe stocks will do well over the long run.

Stocks are not risk free, but from a long-term perspective, they are probably less risky today than they were when the Dow was at 14,000. Yet at 14,000, investors were happy to buy stocks--many using lots of margin. But now, most investors are simply too scared to buy. Who knows when (if ever) the Dow will hit 36,000, but it's a good bet that it will hit 10,000 again--perhaps sooner than we think.

Beware the U.S. Congress

There are plenty of conflicts and problems going on around the world, each vying for the attention of global investors. The war between Israel and the Palestinians is currently on the front burner. It's a conflict that threatens to pull in Iran, which continues in its race toward a nuclear weapon. The wars in Iraq and Afghanistan are still going on. Terror attacks in Mumbai threaten to break the shaky peace between Pakistan and India. And Russia is flexing its muscles by threatening former Soviet republics and restricting the flow of natural gas to Ukraine and Western Europe.

Given all these seemingly intractable problems, which poses the biggest risk for investors? According to Ian Bremmer of the Eurasia Group, the top risk of 2009 is financial regulation in the United States and the rising power of Congress.

Bremmer reminds us that following our last financial crisis, Congress gave us the Sarbanes-Oxley act. We are likely to get something much more onerous this time. The bottom line is that there will be considerably more regulation. Congress will try to regulate everything from the rating agencies to complex financial securities. It will also reform the regulatory agencies. The risk is that Congress may make things worse by delivering bad regulation or simply going overboard in a manner that prevents innovation.

Bremmer also worries that government is getting involved in the actual management of private enterprises. It already holds large stakes in publicly-traded companies, and there is talk of a car czar to oversee the automobile industry.

Finally, Bremmer is concerned that fiscal policies meant to spur the economy may fail. Infrastructure spending, for example, may end up doling dollars to favored pork barrel projects instead of targeting the most worthy programs.

The Eurasia Group is perhaps the best political risk consultancy in the world. It certainly is an ominous sign that this highly-respected firm thinks the U.S. Congress poses the greatest risk to investors in 2009.

Cut Property Taxes Now

According to the S&P/Case-Shiller 20-city Home Price Index, housing prices peaked in July 2006. They have fallen 23% through October 2008. With employment falling, housing prices will no doubt go lower in coming months.

If there is any good news in this, it is that the affordability index is improving. This index tries to give us some sense of how affordable the median priced house is for the median income family. In addition to housing prices, the affordability index considers mortgage rates, which have also come down largely due to government intervention.

Unfortunately, the affordability index ignores an increasingly important cost of home ownership: property taxes. Prospective home buyers in many parts of this country, especially the Northeast and Midwest, must pay close attention to this cost before signing on the bottom line. For many homeowners the monthly outlay for property taxes now rivals their monthly payment toward principal and interest.

This economic recession we are currently struggling through was largely brought on by the collapse of housing prices. The recession won't end until housing prices stabilize. Lower mortgage rates are certainly helpful, but reducing property taxes would go a long way to provide a much needed boost to the housing market. Obviously, the federal government has no role here. It is up to local municipalities to cut property taxes. Like the rest of us, they need to trim their budgets and live within their means. Otherwise, more neighborhoods will be plagued with vacant and foreclosed homes.

Class A Sleuth

A dozen years ago, when I was on the faculty at Boston College, I was teaching in the Master of Science in Finance program. One of my students was a quantitative analyst at a hedge fund. This guy was an excellent student who instinctively understood derivatives and their pricing models. He was an active member of the Boston Security Analysts Society and provided great encouragement as I toiled with the CFA exams.

I joined Forbes in 1997. Every now and then I spoke with this former student of mine. Eventually, he quit his job. He told me he had become disillusioned with the whole Wall Street game and was convinced there was a lot of fraud going on in the industry. He said he was going into business for himself investigating fraud in the securities industry. Without being specific, he said he was on to one of the biggest Ponzi schemes ever. He also told me about his frustrations dealing with the SEC.

Sounds kind of paranoid, doesn't it? I knew this guy wasn't crazy, but I had to wonder if he wasn't exaggerating a bit. Well, imagine my surprise when I read about him on the front page of the Wall Street Journal on Thursday morning. His name is Harry Markopolos and he has been mentioned on my blog before. It turns out the Ponzi scheme Harry was looking into was the one run by Bernie Madoff.

Thanks Harry for doing such a great service to your country. I wish the powers that be had paid more attention to what you had to say long ago.

Facebook Friend

One of the best things about Facebook is that it allows you to track down long lost friends. That's how I found Mark Stivers, the kid who lived three houses down from me when we were growing up. Mark is a multi-talented individual. It turns out he is also an excellent cartoonist. I suggested he draw this cartoon of Ron Gettelfinger, which fits in nicely with my Dec. 12 post. I hope to feature Mark's work from time to time in the Forbes Growth Investor.

The UAW has Priced Itself Out of the Auto Market

When the $14 billion bailout for the auto industry fell through last night, Senate Majority leader Harry Reid said, "I dread looking at Wall Street tomorrow. It's not going to be a pleasant sight."

Stocks opened lower as Reid predicted, but not nearly as much as his words suggested. And soon after the open, stocks began to rally. Some will say investors grew hopeful that the White House and Treasury Secretary Henry Paulson would step in and use TARP money to save the auto industry. However, I believe investors are simply pleased that Congress is taking a hard stand against bailout seekers. Bad companies should be allowed to fail. At least some of our politicians have finally gotten that message.

Ron Gettelfinger, president of the United Automobile Workers, gave a press conference this morning blaming Republicans for the failure of the bailout, but the conference only proved how defensive Gettelfinger has become. The U.S. auto industry is dying, yet the UAW refused to allow any wage concessions in 2009. The UAW doesn't seem to understand that it has priced its membership out of the market. While this union tries to "protect" its members, foreign manufacturers are grabbing market share and putting Americans to work throughout the South. It won't be long before out-of-work union members begin migrating south seeking employment at these non-union shops.

Initial Jobless Claims Get Worse

The Department of Labor reported today that initial jobless claims for the week ending December 6 hit 573,000 on a seasonally-adjusted basis. The news is certainly unsettling. Nonetheless, even though the number exceeded the consensus estimate by almost 50,000, the stock market gave the report a rather ho-hum reception.

Because the week-to-week initial claims figures can be volatile, economists prefer to focus on the four-week moving average. This average climbed to 540,500. It has risen six weeks in a row. During the previous recession (March to November 2001), the 4-week average climbed five weeks in a row before peaking at 489,250. I suspect, however, that this time we haven't yet hit the peak. The graph above plots the 4-week moving average ever since the 2001 recession began. As you can see, it has been rising sharply since late 2007, and so far shows no sign of leveling off. I really don't think it is alarmist to suggest that the unemployment rate could hit 8-9% by mid-2009.

Dismal Employment Numbers May Mark Bottom in Stocks

Today the Bureau of Labor Statistics released the employment figures for November. They weren't pretty. Nonfarm payrolls fell by a much bigger-than-expected 533,000. Even worse, the September and October figures were revised. October's job losses went from 240,000 to 320,000. September's went from 284,000 to 403,000.

The service sector alone lost 370,000 jobs in November. Losses were widespread from retail to automobile dealerships to leisure and hospitality. Health care was the only bright spot, gaining 34,000 jobs.

Surprisingly, the unemployment rate ticked up to just 6.7%. No doubt, this measure will rise considerably in coming months. I was criticized for suggesting it could surpass 8% by mid 2009. I sincerely hope I am wrong about that.

So far in 2008, the economy has lost an astounding 1.9 million jobs. It won't be easy to put all these people back to work on short notice. But that is exactly what President-elect Barack Obama hopes to do. Part of his economic stimulus plan is to increase infrastructure spending by $60 billion over 10 years. He estimates this will create about two million jobs--about the same number of jobs lost so far this year.

The American Society of Civil Engineers estimates that $1.6 trillion is needed just to bring all U.S. public works to good condition, so increasing spending on infrastructure is certainly a good idea. It is also inevitable. But $60 billion over 10 years is just a drop in the bucket. Despite so many other priorities right now, such as bailing out the the finance and auto industries, this figure is likely to rise.

The market initially responded to the employment figures just as one might expect. It sold off. Yet by the end of the day, stocks were up. The Dow finished higher by 259 points. I don't think investors are wrong to bid up stocks right now. The recession, which started a year ago, is already growing long in the tooth; and when employment numbers get this bad, it often marks a bottom in stocks. I continue to expect a strong rally in 2009.

How Low Can It Go?

No, I'm not talking about the stock market. I'm talking about crude oil and gasoline.

Back when oil prices were still well over $100 per barrel, I wrote in Forbes magazine that they were likely to fall. I thought the global slowdown and the rapid change in driving habits would bring oil down to about $70. Of course, we've already fallen well below that mark. Crude is now selling for less than $50. Gasoline prices have also plunged. According to the AAA Fuel Gauge Report, the national average retail price for regular unleaded gasoline is currently $1.93 per gallon.

It would be nice if prices were falling because the world had discovered a lot more oil. Unfortunately, prices are falling because demand is being destroyed. Much of the demand destruction is due to the global economic slowdown. In particular, people are driving less in the U.S. They are also driving more efficient cars. U.S. auto manufacturers are struggling in part because no one wants to buy a gas guzzler anymore. The Honda Civic is suddenly chic.

Other countries are being impacted as well. Europe and much of Asia are in recession. Although demand is still growing in China, it is growing at lower-than-expected rates.

So how low can oil go? It all depends on the severity of the global recession. It also depends on how serious we remain about alternative energy. Plug-in hybrids and all-electric vehicles seemed to make economic sense when oil was at $140 per barrel and $5 gasoline was within sight. But how many drivers would be willing to give up their internal combustion engines if gasoline is expected to remain below $2 per gallon?

Not long ago, no one seriously thought we'd see $40 crude oil again. However, now it appears that we'll see $30 very soon.

This Recession Will Last Longer Than Average

Most sensible economists agree the U.S. economy is in recession. Yet the fact remains that no recession has been officially declared.

The textbook definition of recession is two successive quarters of contraction. After posting very strong growth during the second and third quarters of 2007, GDP fell 0.2% during the fourth quarter of that year. However, it rebounded to 0.9% growth in the first quarter of 2008. The tax rebate checks, billed as an economic stimulus plan, boosted second quarter 2008 GDP to 2.8%. GDP fell 0.3% in the third quarter. So if the economy contracts during the fourth quarter, which it certainly will, we will have satisfied the textbook definition of recession.

The more relevant definition, however, is the one stated by the National Bureau of Economic Research. This is the entity that has the authority to declare official recessions in the U.S. According to the NBER, "a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales." By this definition, it appears that a case could be made that we have been in recession for almost a year.

The NBER takes its time in declaring recessions. According to the NBER, the last recession began in March 2001 and ended in November of that year. But the NBER did not declare the start of the recession until November, when the recession was already over. Furthermore, it did not declare the end of the recession until July 2003. That's almost two years after the recession had already ended.

Employment is one of the many factors the NBER studies when trying to determine if the economy is in recession. In December 2006, the unemployment rate stood at 4.6%. One year later, it had climbed to 5.0%. After dipping a bit in January and February of 2008, it resumed its upward drift. The unemployment rate for October hit 6.5%, 150 basis points higher than it was just 10 months earlier. The last time the unemployment rate visited this level was in April 1994.

Given layoffs like the one announced yesterday by Citigroup, there is no doubt unemployment will jump to much higher levels. Some economists hope the unemployment rate will peak around 7%. I think this forecast is much too optimistic. In June 1992, the unemployment rate hit 7.8%. In November and December of 1982 it peaked at 10.8%. Furthermore, it is not unusual for the unemployment rate to continue rising for some time even after a recession has ended. This is because employers are wary about hiring until they are convinced that better times lie ahead. At this time, I am expecting the unemployment rate to rise to somewhere between 8-9% by June 2009.

I believe the current (undeclared) recession began in January 2008. I am optimistic that it will end around June 2009. If I have the starting and ending points right, this recession will have lasted 18 months in duration. That is about the average length of all recessions recorded in the U.S. since 1854, but it is 10 months longer than the average since 1945. In fact, 18 months would set a post-WWII recession record.

Of course, if businesses become more aggressive with layoffs, retail sales continue to fall, and housing prices fail to stabilize by next spring, this recession could last considerably longer than 18 months. That would be a dire outcome indeed.

Tax-Related Selling Will Keep Market Volatile Until 2009

The following is from a Special Report sent to subscribers of the Forbes Special Situation Survey.

In our Oct. 7 Special Report we discussed the unprecedented level of volatility plaguing the markets. Things have gotten much worse since. Both the intra-day and inter-day swings on the Dow and other major indexes are simply mind boggling. There have been a number of days when the Dow opened up or down several hundred points only to finish in the opposite direction.

We believe this volatility will continue through the end of the year. We believe much of it is due to tax-related trading. Earlier this year, many investors sold stocks for hefty capital gains. They then invested that money back into the market. Now they are sitting on large capital losses. These investors will sell shares in order to realize those losses to offset their earlier gains in order to minimize their tax bill. This activity puts downward pressure on stocks.

Other investors have already realized large capital losses. Because the IRS limits investors to only $3,000 per year in net capital losses, these investors have an incentive to sell into rallies in order to realize whatever gains they can to offset their large losses. This activity keeps the market from going higher than it otherwise would.

Of course, on top of all this, hedge funds and mutual funds are selling in order to meet redemptions. Investors who want their money back from hedge funds by yearend must notify them by Nov. 15. If large numbers of investors do so, selling pressure could increase between now and the end of the year. Mutual funds are also selling heavily. Many investors who have seen the value of their mutual fund holdings collapse will be doubly shocked when they realize they will owe capital gains taxes on shares the mutual fund managers sold at a profit.

Given the extreme sell-off in stocks this year, subscribers should keep a watchful eye on their tax situation. Make sure you realize net losses of $3,000 ($1,500 if married and filing separately). If you realize more than that, you will have to carry forward the losses into the next tax year. That’s not a bad thing, but it is not as valuable as taking them now.

Once all this tax-loss selling is completed, the market will stabilize. We expect volatility to subside once January rolls around. Furthermore, even though the economy will exhibit tremendous weakness for at least another six months or so, the stock market is likely to rally long before the economy improves. A strong rally after a bad year is not unusual. A 50% rally in the Dow from current levels would bring us back to only about 12,750. A 25% rally translates into a 10,625 Dow. This is a level that looks quite achievable by the end of 2009.

Give (Small) Businesses a Chance to Flourish

I gave a talk yesterday at William Paterson University in Wayne, NJ about the economy and stock markets. Many of the participants were small business owners and were very concerned about how the dismal economic climate will affect small businesses in particular.

Small business is the backbone of the U.S. economy. It accounts for about half of all private sector employment, but it also accounts for most of the job growth. At least it did during the last decade. These days, of course, there is no job growth. The economy has shed almost 1.2 million jobs over the past 10 months--more than half a million in the last two months alone.

While the failure rate for new businesses is high, the fact is that owning your own business is one of the best ways to achieve economic prosperity. The new Obama administration should consider ways to make it easier for individuals to start and run businesses. One good idea is to exempt all new businesses from taxes for the first five years. Let them build up some steam before you slow them down. Besides, they will employ more people as they grow and the government will get its due from payroll taxes.

Everyone Should Pay Their Fair Share of Taxes, But Not a Penny More

I just returned from the Fourteenth Forbes Cruise for Investors. We left New York City on Oct. 29 and toured the Caribbean. I got off in Angtigua on Nov. 4, but the cruise is still in progress. I arrived at JFK airport around 11 p.m. on the 4th and entered the baggage claim area just as CNN declared Barack Obama the winner of our presidential election. The place erupted in cheers.

Most participants on the investment cruise were resigned to an Obama victory, but they worried about what this would mean for the economy. Of course, Obama has threatened to raise taxes on the so-called rich. Depending on the day, his definition of rich seems to include anyone who makes $200,000 per year or so. I know in some parts of this country this sounds like a good sum of money, but I do not know anyone in the New York City area who makes this amount of money who considers himself rich--especially if he is supporting a family. With the top 1% of income earners already paying 40% of all the federal income taxes, it seems the "rich" already pay way too much tax.

More than one-third of Americans pay no federal income tax at all. Some are honest hard-working people who simply do not make enough money to pay taxes. But others either refuse to work or work in the underground economy. Many grocers, landscapers, painters, waiters, musicians, etc. deal only in cash. Are all these cash-based businesses declaring their income and paying their fair share of taxes? Some experts estimate that the illegal drug trade alone has a global value of $400 billion--all of it tax free. Instead of trying to squeeze more money out of the rich, Obama should first make sure that everyone pays his fair share.